what the market will do is anyone’s guess....

How is it that so many traders and investors lose money in the market, while others—like authors Gil Morales

and Chris Kacher—have shown the ability to earn huge returns on investment? As Bill O’Neil himself says, “Human nature being what it is, 90% of the people in the stock market—professionals and amateurs alike—simply haven’t done enough homework.” Trade Like an O’Neil Disciple: How

We Made 18,000% in the Stock Market is your homework. And if you invest in the market, you can expect that there will be a test involving your own money.

Th e result of years of observation and the subsequent application of the commonsense rules learned, Trade Like an O’Neil Disciple details the small realities that make up the stock market, including:

• Th e importance of a 6–7% automatic stop-loss policy on stock purchases

• Sit tight and be right, or “take your profi ts slowly”

• Th e value of psychological capital, and how mastering your own psychology allows you to operate from a position of strength

• Position concentration, and how diversifi cation—“kissing all the babies”—is unnecessary

• How timing the market is possible and necessary, despite claims to the contrary by those who can’t

• Mistakes novices or lazy investors make, such as averaging down or purchasing only cheap stocks

• How O’Neil applied historical precedent to box theory to come up with consolidation patterns (“bases”), such as: ascending; cup-with-handle; double-bottom; square box; fl at base; and high, tight fl ag

$60.00 USA / $72.00 CAN

• Using early buy points in the form of “pocket pivots” to gain an advantage in diffi cult market environments

• Using gap ups as buy points to jump on board of some of the most powerful stocks

• Th e fi ner points of O’Neil-style short-selling techniques

It took years to identify, analyze, catalog, and verify the characteristics of winning stocks for O’Neil to fi nally perfect his system. Authors Gil Morales and Chris Kacher save you the time and—if you’re an investor, money—by bringing together in one comprehensive guide, the commonsense investment philosophies that allow them and you to Trade Like an O’Neil Disciple.

GIL MORALES is the author and publisher of www.GilmoReport.com; coauthor and publisher of www.VirtueOfSelfi shInvesting.com; a former senior proprietary internal Portfolio Manager and Chief Market Strategist for William O’Neil + Company; and is currently a Managing Director of MoKa Investors, LLC. He also co-authored, with William J. O’Neil, the Wiley title, How to Make Money Selling Stocks Short. Mr. Morales received his BA in economics from Stanford University.

CHRIS KACHER is a frequent contributor to www.GilmoReport.com; coauthor and pub-lisher of www.VirtueOfSelfi shInvesting.com; a former research analyst and senior proprietary internal Portfolio Manager for William O’Neil + Company; and a Managing Director of MoKa Investors, LLC. He received his BS in chemistry and PhD in nuclear physics from the University of California at Berkeley.

(continued on back flap)

(continued from front flap)

“In these historically diffi cult markets where quantitative easing and forced selling are the norm, Gil Morales and Chris Kacher show how to apply, with incredible success, their unique investment tools and methods in an increasingly volatile trading environment. However, beyond their ‘pocket pivot point’ investment method, their short-sale setups and their groundbreaking ‘Dr. K market timing tool,’ what is truly amazing is to learn how professional traders analyze their mistakes and correct them. It is not great tools that make great traders, it is humility and fl exibility combined with decisive action that determines one’s ‘success or failure.’ ”

—Pascal Willain, independent trader and inventor of volume-based indicators,

author of Value in Time

“If you only read one book this year, read this one. It turns everything you know inside out and changes the way you see the things that matter. In a world full of fake promises and hype, here is something real. Morales’ and Kacher’s vision, passion, and dynamism is [proven]by their results. Lots of people talk, they have delivered. If you really want to succeed in a very uncertain world, read this book. It will change your success.”

—Dr. Michael Meegan, author of All Will Be Well

What the market will do is anyone’s guess. What it is doing should be anything but.

From the successes and failures of two William O’Neil insiders, Trade Like an O’Neil Disciple:

How We Made 18,000% in the Stock Market is a detailed look at how to trade using William

O’Neil’s proven strategies, as well as what it was like working side-by-side with the Wall

Street legend.

Detailing both the technical information and the trading psychology that has worked so

well for them, and including a market direction timing model, Trade Like an O’Neil Disciple

breaks down what every savvy money manager, trader, or investor needs to know to profi t

enormously in today’s stock market.

M O R A L E S

K A C H E R

P1: JYSFM JWBT320-Morales July 9, 2010 19:39 Printer: Courier Westford, Westford, MA

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Trade Likean O’NeilDisciple

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Founded in 1807, John Wiley & Sons is the oldest independent publish-ing company in the United States. With offices in North America, Europe,Australia and Asia, Wiley is globally committed to developing and market-ing print and electronic products and services for our customers’ profes-sional and personal knowledge and understanding.

The Wiley Trading series features books by traders who have survivedthe market’s ever changing temperament and have prospered—some byreinventing systems, others by getting back to basics. Whether a novicetrader, professional or somewhere in-between, these books will providethe advice and strategies needed to prosper today and well into the future.

For a list of available titles, visit our Web site at www.WileyFinance.com.

ii


Trade Likean O’NeilDisciple

How We Made Over 18,000% in

the Stock Market

GIL MORALESAND DR. CHRIS KACHER

John Wiley & Sons, Inc.

iii


Copyright C© 2010 by Gil Morales and Chris Kacher. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted inany form or by any means, electronic, mechanical, photocopying, recording, scanning, orotherwise, except as permitted under Section 107 or 108 of the 1976 United States CopyrightAct, without either the prior written permission of the Publisher, or authorization throughpayment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web atwww.copyright.com. Requests to the Publisher for permission should be addressed to thePermissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201)748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their bestefforts in preparing this book, they make no representations or warranties with respect to theaccuracy or completeness of the contents of this book and specifically disclaim any impliedwarranties of merchantability or fitness for a particular purpose. No warranty may be createdor extended by sales representatives or written sales materials. The advice and strategiescontained herein may not be suitable for your situation. You should consult with aprofessional where appropriate. Neither the publisher nor author shall be liable for any loss ofprofit or any other commercial damages, including but not limited to special, incidental,consequential, or other damages.

Charts provided courtesy of eSignal. Copyright 2010 by eSignal.

For general information on our other products and services or for technical support, pleasecontact our Customer Care Department within the United States at (800) 762-2974, outside theUnited States at (317) 572-3993 or fax (317) 572-4002.

Wiley also publishes its books in a variety of electronic formats. Some content that appears inprint may not be available in electronic books. For more information about Wiley products,visit our web site at www.wiley.com.

Library of Congress Cataloging-in-Publication Data:

Morales, Gil, 1959–Trade like an O’Neil disciple : how we made over 18,000% in the stock market /

Gil Morales, Chris Kacher.p. cm. – (Wiley trading series)

Includes index.ISBN 978-0-470-61653-6

1. Stocks. 2. Speculation. 3. Portfolio management. I. Kacher, Chris. II. Title.HG4661.M597 2010332.63′22–dc22

2010013522

Printed in the United States of America.

10 9 8 7 6 5 4 3 2 1

iv


It is said that dedicating a book is one of the most exquisite

acts of love one can perform. I love all who seek out and find

their passion in life and in spirit, which include those closest

to me, you know who you are.

—Chris Kacher

For the other riders in my bumper car of life: Linda,

Claire, and Alex, and for the two people who are responsible

for setting me off on this bumper car ride:

my parents, Bob and Irene.

—Gil Morales

v


Contents

Foreword xi

Preface xiii

Acknowledgments xvii

CHAPTER 1 The Evolution of Excellence:The O’Neil Trading Method 1

Preparation, Study, and Practice 2

Buy Expensive—Not Cheap—Stocks 4

Averaging Down 5

Cutting Losses Quickly 5

Taking Profits Too Soon—Letting Your Winners Run 6

Position Concentration 7

Dealing in Big Stocks and Institutional Sponsorship 8

Chart Patterns 9

Pivotal Points versus Pivot Points 12

Timing the Market: When to Be In, When to Be Out 13

Emotions and Predictions 14

Listening to Opinions, News, and Tips 15

Overtrading 16

The O’Neil Approach: Techno-Fundamentalism 17

Conclusion 17

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viii CONTENTS

CHAPTER 2 How Chris Kacher Made Over18,000 Percent in the StockMarket Over Seven Years 19

Gaining a Foothold in the Business 20

1996—“Y2K” Stocks Put Me Over the Top 22

1997—Keeping Profits during the Asian Contagion 27

1998—Demoralization Sets In Just Before the Market

Takes Off 29

1999—The Bubble Expands 31

2000—The Bubble Bursts 35

2001—A Lesson in Shorting 37

2002 to Present—Choppy, Sideways Markets and the Birth

of the Pocket Pivot 39

CHAPTER 3 How Gil Morales Made Over 11,000Percent in the Stock Market 43

A Rocky Start Turns Golden 44

Climbing on Board the Rocket Ride 46

Joining the 1,000 Percent Club 49

Oracle Bubbles Up 50

Patience and a Watchful Eye 53

Cleared for Take-Off 54

Verisign: The “Spice in the Soup” 56

Sitting Not Thinking 60

Closing In on the Top 62

The Theme of Success 64

The Secret Ingredients 65

CHAPTER 4 Failing Forward 67

The Psychology of Success Lies in Taming the Ego 68

Learning from Our Mistakes 72

Problems, Situations, and Solutions 107

Conclusion 125


Contents ix

CHAPTER 5 Tricks of the Trade 127

Dr. K’s Laboratory: The Pocket Pivot Advantage 128

Characteristics of Pocket Pivots 131

Definition of a Pocket Pivot Buy Point 132

Pocket Pivots and Standard Breakout Buy Points 133

Buying “in the Pocket” 136

Bottom-Fishing with Pocket Pivots 149

Continuation Pocket Pivots: Using the 10-Day Moving

Average 153

Improper or “Do Not Buy” Pocket Pivot Points 157

Using Moving Averages as Sell Guides 163

Dr. K’s Laboratory: Buying Gap-Ups in Leading Stocks 165

Selling Techniques Using the 10-Day and 50-Day

Moving Averages 173

Putting It All Together 177

Conclusion 185

CHAPTER 6 Riding the Bear Wave: Timely Toolsfor Selling Stocks Short 186

The Golden Rules of Short-Selling 187

Short-Sale Set-Ups 192

Shorting Rocket Stocks 221

Conclusion 224

CHAPTER 7 Dr. K’s Market Direction Model 226

Timing the Market 226

Chart Examples 234

Stealing the Model’s Secrets 243

Timing Model FAQ 244

Conclusion 259

CHAPTER 8 Our Bill of Commandments 260

Misconceptions 260

Surviving by Keeping Ego in Check 263


x CONTENTS

The First Commandment 265

The Second Commandment 265

The Third Commandment 267

The Fourth Commandment 267

The Fifth Commandment 267

The Sixth Commandment 268

The Seventh Commandment 268

The Eighth Commandment 268

The Ninth Commandment 269

The Tenth Commandment 269

Conclusion 270

CHAPTER 9 In the Trenches with Bill O’Neil 272

1997–1998 272

1999–2000 286

The Great Bear of 2001–2002 307

2003–2005 Bull Market 318

Conclusion 329

CHAPTER 10 Trading Is Life; Life Is Trading 331

Ed Seykota: Teaching a Technique That Has Helped

Traders around the World 332

Eckhart Tolle: Helping People Achieve Inner Peace and

Greater Fulfillment, a Prerequisite to Optimized

Trading and Living 334

Esther Hicks: Teacher of the Law of Attraction 340

Jack Canfield: Seminal Works on Personal Optimization 341

Psychological Checklist: Questions to Ask Yourself 343

Parallels between Teachings 345

In Conclusion 346

APPENDIX Dr. K’s Top 50 Wall Street Books 347

About the Authors 351

Index 353


Foreword

B ill O’Neil is a passionate student of the markets and one of the mostsuccessful traders of the modern era. From our days at SMU andlater during his time in Alaska, Bill was studying charts and develop-

ing his vast understanding of the markets. Based upon his historical studiesback into the nineteenth century, Bill has always tried to help the investorimprove their success ratios.

His commitment to bringing that knowledge to the average and/or pro-fessional investment community has cost him millions of dollars throughthe subsidization of Investor’s Business Daily R© and other O’Neil projects.

It has been my privilege to have known Bill for almost sixty years andwhile my own investment style is not exactly O’Neil’s, it is built upon thesame building blocks. When I first went to Wall Street in June 1962 (tenyears after meeting WON almost to the day), William T. Golden, the NewYork partner in Cornell, Linder & Co., a member of the NYSE, told me: “Wemostly invest in stocks and convertibles with increasing sales and increas-ing earnings. Go find them, keep your losses under control and everythingwill work out.”

Luckily for me, those few words of wisdom have been the basis of myinvestment style during the past fifty years.

Stripped to its core values that is also basically O ‘Neil’s CAN SLIM R©.O’Neil is often accused of being only a technician, but that is not true.

His investment style builds heavily upon fundamentals, chart patterns, mar-ket trends, sector rotation, and economic strength. O’Neil is also not a fanof modern portfolio theory and often concentrates his portfolio in only afew stocks. Performance, not diversity, is the key to O’Neil’s long-term suc-cess. There have been times when O’Neil’s investment portfolio could be100 percent in cash or concentrated in just one or two positions.

Gil Morales and Chris Kacher learned from O’Neil while working assuccessful portfolio managers at William J. O’Neil + Co., Inc. In this book,they help the investor understand how the CAN SLIM investment systemworks and have added a few tweaks to the O’Neil strategies that they havedeveloped.

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xii FOREWORD

It is evident that they are highly indebted to O’Neil’s philosophy andtrading principles. However, like all traders that are constantly seeking anedge, they have also developed some of their own unique indicators andrules that they disclose in the book.

It is all here, the gains, the losses, both at the O’Neil firm and later ontheir own, the changes in the O’Neil system as market conditions dictate.Wall Street is a big casino and black swans do occur to upset the best laidplans.

Dr. K and Gil make it quite evident that there is a lot to learn fromO’Neil and the CAN SLIM investment system and they are deeply indebtedto WON as are his many legions of admirers for providing the tools to im-prove investment success ratios.

But most important, they also demonstrate that it is impossible to tradelike Bill O’Neil because it is simply impossible to have his unique feel forthe markets. But by understanding O’Neil’s principles, investors can im-prove their success ratios.

Trade Like an O’Neil Disciple fascinated me and I will read it time andtime again to improve my results!

Fred Richardswww.adrich.comwww.stratinv.net


Preface

A s a successful investor, William J. O’Neil has touched the lives of in-dividual and institutional investors around the globe whom he hastaught to make money in stocks. How many we cannot know for

sure, but rest assured that it is likely in the hundreds of thousands, if notfar more. His methods and the investment tools he and his firm have devel-oped for individual and institutional investors alike have empowered manyto find financial freedom in their lives. We are two of those investors, andwe can vouch for the fact that Bill O’Neil is responsible for helping to cre-ate many new millionaires in this world. As former internal portfolio man-agers at William O’Neil + Company, Inc. we met many individual and insti-tutional investors who benefitted from O’Neil’s strategies and expertise, sowe know this from first-hand experience. We’ve also made lots of moneyin the markets, thanks to learning and executing O’Neil’s methodologies.

This book is our attempt to articulate what we learned from Bill O’Neil,working directly with him under fire in real-time while trading the markets.But first a disclaimer: this book is not sanctioned by or approved by BillO’Neil or William O’Neil + Co., Inc. Our interpretation and views may notbe those of Bill or the company. This book explains how we trade basedon our learning experience as proprietary traders at William O’Neil + Co.,Inc. This book is also not about the CAN SLIM R© methodology. Readersare encouraged to read Bill’s seminal work (and all his other books), How

to Make Money in Stocks, and to refer to Investor’s Business Daily andinvestors.com. Between Bill’s excellent books, the reporting in the paper,and the web site, there is a plethora of tutorials and educational materialsthat detail O’Neil’s methods. We encourage you to make good use of thesebooks and tools.

Trade Like an O’Neil Disciple is our unique experience with this manwho we feel is likely the world’s greatest investor. In this book we pro-vide insights into O’Neil’s genius as we saw it. We track the markets ofthe late 1990s and early 2000s with real-time excerpts from our tradingdiaries that bear witness to O’Neil’s incredible investment genius. In real-time, O’Neil embodies the Latin term speculari, which means “to spy out or

xiii


xiv PREFACE

examine” as he perceives subtle shifts in the market, almost by osmosis. Inthis book we hope to provide insight into some of his thought processes, aswe saw them unfold, using real-time market examples. The O’Neil method-ologies primarily represent a dynamic approach to the stock market, andthis dynamism is entirely correct and appropriate since the stock marketis itself a dynamic beast. The brutal bear markets of 2000–2002, and 2008have proven that “static” buy-and-hold strategies are a fantastic way to losea lot of money. The markets are dynamic and O’Neil’s methods are like-wise dynamic, yet we are still human beings with our foibles and quirks.O’Neil advises making up “little rules” along the way as you observe yourown trading and recognize these little “quirks” in yourself. These little rulesmay be sub-systems or rules that establish boundaries for containing weak-nesses or are put in place to capitalize on strengths. We ourselves, as long-term, experienced practitioners of O’Neil methodologies, have come upwith many over the years. It’s not as if we are turning the system upsidedown, or using it in piecemeal fashion as we pick and choose what ruleswe choose to use. Instead, what we have done over time is to use the mar-ket as an effective feedback system with respect to our own trading tocome up with small rules and sub-systems that enhance our own approachto O’Neil’s methods. One of our “quirks” is that we like to buy stocks earlierin bases, and not just when they stage an obvious new-high base-breakout.Another “quirk” of ours is that we like to buy gap-ups, particularly in astrong leader as it is breaking the “line of least resistance” to the upsideand potentially embarking on a sharp price run. In this book we share withyou trading rules that have worked well for us, and how we buy stocks andshort stocks using refined “sub-methods” that we have tested both statisti-cally and in practice, and have found to be effective enhancements to ourinvesting.

We’ve also made a lot of mistakes, and in this book we discuss thosemistakes in order to help prevent you from making the same mistakes,hopefully saving you time, money, and misery in the process.

Trading for us has been as much a spiritual journey as it has been aninvesting journey, and in the process has provided each of us with a mi-crocosm of life itself. The return of +18,241.2 percent works out to +110.5percent on an annualized basis over the seven-year period from January1996 to December 2002. But to achieve such a result, a couple of sizeabledrawdowns did occur including one that was nearly −50% during the sec-ond and third quarter of 1999. As well, we would point out that the returnswe discuss in Chapters 2 and 3 were achieved in our personal accounts,and not in the accounts we managed for William O’Neil + Company, Inc.

While the dollars in our trading accounts and the returns are the waywe track our success and performance, trading is ultimately not so muchabout making money as it is about understanding what Eckhard Tolle


Preface xv

referred to as “The Power of Now.” Like athletes and thrill-seekers whoengage in activities that seem extremely dangerous, almost to the point ofthe unthinkable to those who live more normal lives, we as traders seekthe “rush” that comes not from a successful trade, but from the experi-ence of being entirely in the present as we operate “in the zone” and acertain fluidity and calmness pervades our actions as we engage the mar-kets in real-time. Ocean wave surfers experience this as the intensity ofriding a powerful wave-form that forces them to focus on the matter athand as a matter of sheer survival. Focusing on the matter at hand forcesone to operate entirely in the present—there is no worrying about yester-day’s problems, or tomorrow’s challenges, there is only the “now.” If youcannot understand why someone would seek to ride a 50-foot-high “deathwall” of ocean water then you likely have never ridden one. Riding such awave is the rush—what we call being “in the zone”—and it applies to trad-ing as much as it applies to surfing, hang-gliding, rock-climbing or any otherdangerous yet exhilarating endeavor that humans are drawn to like mothsto a porch light. As traders we both share an appreciation for the spiritualaspects of this phenomenon, which is really nothing more than the simple,spiritual act of “becoming one” with the present moment; nothing more,nothing less. This is the essence of successful trading.

Gil MoralesDr. Chris Kacher

June 2, 2010


xvi


Acknowledgments

W hile it is always important to acknowledge those who assisted inthe production of a book such as this, we feel it is just as importantto acknowledge that this book was written and produced with ab-

solutely no assistance, endorsement, or cooperation from William J. O’Neilor any of the O’Neil organizations. This is an independent work. However,there were many people who are responsible in some way, large or small,for this book that you now hold in your hands. Among these, we wouldlike to thank Mike Scott, who provided invaluable technical assistance increating the charts for this book, the folks at eSignal, who let us use theirexcellent charts and data, Rachel Hain, who helped on several fronts dur-ing the writing of the book, and Kevin Marder.

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P1: OTAc01 JWBT320-Morales July 8, 2010 14:55 Printer: Courier Westford, Westford, MA

C H A P T E R 1

The Evolution ofExcellence

The O’Neil Trading Method

A s portfolio managers who once ran money for William J. O’Neil,we have observed that a meaningful portion of the O’Neil “body ofthought” is derived from the philosophies of those who preceded

him, particularly the works of Richard Wyckoff and Jesse Livermore. Whenit comes to market thought, you can never entirely understand Bill O’Neiluntil you have read and understood these two gentlemen. Obviously, thetechniques and philosophies of the famous trader Jesse Livermore, aspresented in the classic Reminiscences of a Stock Operator, by EdwinLefevre and Livermore’s own How to Trade in Stocks, figure heavily in theunderlying pulse that governs the way Bill O’Neil and his stable of portfoliomanagers trade. Richard Wyckoff, as one of the first to write about JesseLivermore in his original work, Jesse Livermore’s Methods of Trading

Stocks, espoused much of the common sense investment philosophiesand maxims that have found their way into the writings and investmentthought of William J. O’Neil. Even Nicolas Darvas, in his famous book,How I Made $2 Million in the Stock Market (Carol Publishing Group,1998), laid the foundation for O’Neil’s “chart bases” with his own “boxes,”which he described as simply normal consolidation channels within whicha stock’s action was judged to be normal or abnormal.

The themes that echo from Wyckoff, Livermore, Darvas, and oth-ers weave the essential fabric from which “O’Neil–style” investmentmethodologies are cut. These methodologies utilized the work of O’Neil’spredecessors by bringing into play the time-tested characteristics ofwinning stocks that O’Neil painstakingly identified, analyzed, catalogued,and verified in his numerous Model Book Studies, some of which your

1


2 TRADE LIKE AN O’NEIL DISCIPLE

authors had the privilege of producing and contributing to. By siftingthrough the best-performing, institutional-quality leading stocks in eachand every type of market cycle, O’Neil identified their key commoncharacteristics, the most basic of which provided the genesis for O’Neil’sunique stock-selection template, commonly known to the investing publicas CAN SLIM. Certainly, O’Neil owes a debt to the thinking of Livermore,Wyckoff, and others, and the roots of the O’Neil investment methodologiesrun deep in this regard. However, as former portfolio managers for WilliamO’Neil + Company, Inc., we can vouch for the fact that such roots do notimply that O’Neil simply copied his predecessors. That would be a grossoversimplification, since the truth is that the O’Neil methodologies tookthe thinking of these outstanding stock market investors from the past toa much higher level by bringing greater clarity to the process as he formu-lated a concrete, concise, and practical approach to making money in thestock market.

The parallels between O’Neil and his predecessors provide an over-arching backdrop to a general philosophy, a certain ethos, if you will, to-ward the market that is more than just Livermore’s, or Wyckoff’s, or evenO’Neil’s. As O’Neil himself used to tell us, “It’s not MY system. It’s themarket’s, because it is based on how the market actually works.” In thismanner, O’Neil simply sees his own work as furthering the basic processof understanding the market through observation and the application ofcommon sense rules gained thereby. It is nothing more or less than under-standing all the small realities that make up the stock market. Reviewinghow O’Neil has taken and expanded upon the works of his predecessors isa useful exercise, and sets the backdrop for much of the research we havedone to further our approach to the O’Neil/Livermore/Wyckoff approach tothe market, and which is one of the main topics of this book.

PREPARATION, STUDY, AND PRACTICE

Don’t dabble in stocks. Dig in and do some detective work.

—William O’Neil, How to Make Money in Stocks,

2nd ed. (New York: McGraw-Hill, 1995), 34

This the essential premise of O’Neil methodologies: They are in no way,shape, or form intended as a panacea for making money in the market.Human beings are complex organisms, and so represent the greatest vari-able in the implementation of any investment methodology, whether of“O’Neilian” origin or otherwise. This is why O’Neil insists that one mustput in the time, effort, and work required if one intends to become a


The Evolution of Excellence 3

successful stock market investor: “Human nature being what it is, 90 per-cent of the people in the stock market, professionals and amateurs alike,simply haven’t done enough homework.”

O’Neil laments the fact that so many investors are looking for somemagic formula that enables them to produce an optimal result in the stockmarket with little or no effort. In The Successful Investor, he laments the“rise of the individual investor” during the dot-com bubble market of 1999.“Most people, both investors and advisors, got hurt in the 2000 to 2002downturn because they never took the time to learn sound investment rulesand principles. In the 90s they thought they’d found a way to make moneywithout doing much homework. They just bought tips, touts, and sto-ries” (William J. O’Neil, The Successful Investor [New York: McGraw-Hill,2004], xii).

While most investors do not hesitate to dabble in the markets, theywould rarely dabble in medical or legal practice, or even in playing pro-fessional baseball. O’Neil reminds us, however, “Outstanding stockbrokersor advisory services are no more frequent than are outstanding doctors,lawyers, or baseball players” (William O’Neil, How to Make Money in

Stocks, 2nd ed. [New York: McGraw-Hill, 1995], 256). This is not too far offfrom Richard Wyckoff’s astute observation that “A person becomes com-petent in other fields because he has generally gone through a long periodof practice and preparation. A physician, for example, goes to college, at-tends medical clinics, rides in an ambulance, serves in hospitals, and aftersome years of preparatory work, hangs out a sign. In Wall Street, the sameM.D. would hang his sign first; then proceed to practice” (Richard Wyckoff,How I Trade and Invest in Stocks & Bonds [New York: The Magazine ofWall Street, 1924], 159–160).

Investing is hard work, and an investor requires no less preparationand expertise than any other white shoe professionals practicing theircraft, whether it be law, medicine, software design, moviemaking, or oth-erwise. Jesse Livermore became annoyed when he was approached byfriends or acquaintances who would ask him how they, too, could makemoney in the market. Biting his tongue, Livermore’s answer eventuallyevolved into a curt, “I don’t know,” as he found it difficult “to exercise pa-tience with such people. In the first place, the inquiry is not a complimentto a man who has made a scientific study of investment and speculation. Itwould be as fair for the layman to ask an attorney or a surgeon: ‘How canI make some quick money in law or surgery?”’ (Jesse Livermore, How to

Trade in Stocks [Greenville: Traders Press, 1991], 15).While reminding investors that success can only be achieved by hard

work and persistence, O’Neil, always the optimist, makes it plain that suc-cess is within the reach of anyone willing to make the effort, and in hisbook, How to Make Money in Stocks (2009, 9), he urges us all on with a



touch of self-sufficient idealism, “The American dream can be yours if youhave the drive and desire and make up your mind to never give up on your-self.” But O’Neil insists from the start that, as Wyckoff wrote, “. . . anybodywho thinks he knows of a short-cut that will not involve ‘sweat of the brow’is sadly mistaken” (How I Trade and Invest in Stocks & Bonds [New York:The Magazine of Wall Street, 1924], 93).

BUY EXPENSIVE—NOT CHEAP—STOCKS

Like Livermore, O’Neil despises a lazy approach to the market because itresults in one trying to take what is perceived as the easy route to stockmarket riches. Nowhere else is this more embodied than in the idea of buy-ing stocks that are “cheap.” This age-old trap is easy to fall into, since mostnovice investors approach the market with an incorrigibly ingrained con-sumer mentality that views anything selling today at a lower price than itwas yesterday as a “bargain.” This is perhaps because the individual in-vestor views herself as a consumer endpoint, when in fact the investorshould act like a business that purchases raw or finished goods and intendsto turn around and sell them at a higher price. Hence, O’Neil’s story aboutred dresses and yellow dresses, where the slower-selling yellow dressesare marked down by the store owner to get them out of the “portfolio,”otherwise known as the store inventory, so that more of the hotter-sellingred dresses can be purchased and resold at higher prices.

O’Neil advocates buying stocks that are “red dresses” selling “like hot-cakes” at all-time high prices. The reason for this is simple: “. . . real leadersstart their big moves by selling at new price highs, not near new lows or offa good amount from their highs” (How to Make Money in Stocks, 4th ed.[New York: McGraw-Hill, 2009], 426). In a contrarian sense, this is whatmakes the concept of buying stocks at new highs so effective. It is simplynot obvious to the crowd, who fear buying a stock that looks to be sellingat such a high price, because, as O’Neil points outs, “What seems too highin price and risky to the majority usually goes higher eventually, and whatseems low and cheap usually goes lower” (2009, 174). The market tries tofool the majority of investors the majority of the time, so if new high pricesin a particular stock make the crowd timid about buying it, then that islikely the precise time to be buying the stock.

Like O’Neil, Jesse Livermore appreciated higher-priced stocks far morethan “cheap” stocks, advising, “One should never sell a stock, because itseems high-priced. . . . Conversely, never buy a stock because it has hada big decline from its previous high. The likelihood is that the decline isbased on a very good reason. That stock may still be selling at an ex-tremely high price relative to its value—even if the current level seems



low” (Jesse Livermore, How to Trade in Stocks [Greenville: Traders Press,1991], 25).

AVERAGING DOWN

Trying to buy cheap stocks is but one frequent sin committed by novice orlazy investors. Another lazy man’s sin eschewed by O’Neil and his prede-cessors is the concept of “averaging down.” Richard Wyckoff observed, “Agreat deal of money is lost or tied up by people who make a practice ofaveraging. Their theory is that if they buy a security at 100 and it goes to90, it is that much cheaper, and the lower it goes the cheaper it grows.”

Retail stock brokers, when in need of a way to avoid taking responsibil-ity for a bad recommendation, often try to use “averaging down” as a wayto justify the initial decision to purchase a stock at higher prices. To someextent, this evolved as a convenient corollary to the retail investment con-cept of “dollar-cost averaging” when purchasing mutual funds, about whichwe’re sure many readers are only too familiar. To O’Neil, this is shameful:“About the only thing that’s worse is for brokers to take themselves off thehook by advising customers to ‘average down.’ If I were advised to do this,I’d close my account and look for a smarter broker” (How to Make Money

in Stocks, 4th ed. [New York: McGraw-Hill, 2009], 247).Jesse Livermore was no less harsh in his assessment of the averaging-

down technique when he said, “It is foolhardy to make a second trade, ifyour first trade shows you a loss. Never average losses. Let that thoughtbe written indelibly upon your mind” (How to Trade in Stocks [Greenville:Traders Press, 1991], 26). Richard Wyckoff took the concept just a little bitfurther by adding, “It is better to ‘average up’ than to ‘average down”’ (Stock

Market Technique Number 1 [New York: Richard D. Wyckoff, 1933], 50).And as we know, O’Neil contrasts his sermons against averaging down bystrongly advocating “averaging up” on one’s winning stocks.

CUTTING LOSSES QUICKLY

Jesse Livermore wrote in How to Trade in Stocks, “You should have a cleartarget where to sell if the market moves against you. And you must obeyyour rules! Never sustain a loss of more than 10 percent of your capital.Losses are twice as expensive to make up. I always established a stop be-fore making a trade” (How to Trade in Stocks [Greenville: Traders Press,1991], 171). O’Neil advises a 7 to 8 percent automatic stop-loss policy onall stock purchases, and the main reason for this is to keep oneself out of



danger. Huge losses in the market can be debilitating, and O’Neil views astrict stop-loss policy, whether at his threshold of 6 to 7 percent or Liver-more’s 10 percent, as absolutely necessary for survival in the stock market.Livermore observed, “Taking the first small loss is wise . . . profits take careof themselves but losses never do” (1991, 7).

Richard Wyckoff in Stock Market Technique Number 1 advised: “Yourfirst line of defense is a stop order—placed when you make the trade, orimmediately thereafter. If you fail to limit your risk at inception, make apractice of looking over your commitments every day, or twice every weekand selling out, at the market, all showing a loss. That will keep your sheetclean and allow your profitable trades to run until the time comes to closethem out” (1933, 96). This concept of using a stop-loss as a “line of de-fense” runs parallel to O’Neil’s thinking that “letting your losses run is themost serious mistake made by almost all investors” (How to Make Money

in Stocks, 2nd ed. [New York: McGraw-Hill, 1995], 93) simply because “[i]fyou don’t sell to cut your losses when you get into trouble, you can eas-ily lose the confidence you’ll need to make buy and sell decisions in thefuture” (1995, 252). Not only do losses cut into the capital an investor hasavailable to capitalize on potential opportunities in the stock market, theyalso take their toll on an investor’s psychological capital, their all-importantself-confidence.

To O’Neil, Livermore, and Wyckoff, losses are just part of the process,and it is always better to take a little pain now rather than a lot of pain later,because, as O’Neil reveals, “The whole secret to winning big in the stockmarket is not to be right all the time, but to lose the least amount possiblewhen you’re wrong” (1995, 240).

TAKING PROFITS TOO SOON—LETTINGYOUR WINNERS RUN

The O’Neil methodology is essentially a trend-following system—you wantto be in the market when the trend is in your favor, and you want to capturea large portion of any trend by riding with it for as long as possible. ToO’Neil, buying a winning stock is only half the problem, because the key tocapitalizing on a big price move in any potential, big, winning stock is inhow you handle the stock once you have bought it. As Livermore said, itis the uncommon man who can “sit tight and be right,” so sitting with andproperly handling a meaningful position in a big, winning stock through thebulk of its upside price move is a big part of how O’Neil makes big moneyin the stock market. This necessitates adhering to a basic principle thatLivermore stipulated when he said, “As long as a stock is acting right, and



the market is right, do not be in a hurry to take a profit” (How to Trade in

Stocks [Greenville: Traders Press, 1991], 21). You can’t make big money instocks if you don’t give them a chance to make big money for you.

O’Neil recommends “take your losses quickly and your profits slowly,”because “your objective is not just to be right but to make big money whenyou are right” (How to Make Money in Stocks, 4th ed. [New York: McGraw-Hill, 2009], 247–272). Trading for quick profits requires that one be con-stantly active and thinking about the next trade. It is a notoriously busyway to approach the market, and is entirely out of sync with the ideal thatO’Neil–style investing tends toward. In our experience, there is nothingeasier than making big money in the market once you have latched ontoa big winner, because at that point all you are doing is sitting more andthinking less. When your stocks are trending nicely to the upside and youare fully invested, there is, from a practical standpoint, very little to do. Youare simply letting your winners run. This is what we like to call “being inthe zone,” a mental space that derives from Livermore’s principle: “It neveris your thinking that makes big money. It’s the sitting” (Edwin Lefevre,Reminiscences of a Stock Operator [New York: John Wiley & Sons,1994], 68).

Richard Wyckoff had his own unique perspective on the idea of cut-ting losses quickly and letting winners run when he wrote in Stock Market

Technique Number 1, “Are you getting rich backwards? Then you are tak-ing two points profit on your speculative trades and letting your losses run.Why not reverse this rule? Limit your risk to one, two or three points andlet your profits run” (1933, 52).

POSITION CONCENTRATION

A big part of handling a winning stock correctly is properly scaling one’sposition size. If you only want to make average market returns, then scaleyour positions to a very small size, and your portfolio will act very muchlike a market index. Having scores of positions is nothing more than “closetindexing.” Most mutual fund managers take positions that make up 1 to2 percent of their portfolio equity or less, and they may have 100 to 200 posi-tions or more. To O’Neil, this is anathema. If you want to make big returns,then you absolutely must concentrate your capital in a strongly-trendingstock, and position sizes of 1 to 2 percent of one’s total portfolio equityare, to put it bluntly, quite wimpy from an O’Neil perspective. The O’Neilmethod of pyramiding into strongly acting positions while weeding outweaker ones generally gets an investor concentrated in the right stocksduring a bull market cycle. At times, your authors have been fully invested



in as few as two stocks, using full, 200 percent margin, so that each positionrepresents 100 percent of the account’s gross equity. This is how you makebig money in the market, and it is the essence of handling one’s stocksproperly to achieve maximum effect.

For this reason, O’Neil eschews “diversification” and cites the wisdomof Gerald Loeb, who declared that diversification was a “hedge for igno-rance.” O’Neil’s solution was to be very specific about what stocks oneowned in any bull market cycle, suggesting, “The more you diversify, theless you know about any one area. Many investors overdiversify. The bestresults are achieved through concentration: putting all your eggs in justa few baskets that you know a great deal about and continuing to watchthose baskets very carefully” (How to Make Money in Stocks, 4th ed. [NewYork: McGraw-Hill, 2009], 274).

The purpose of position concentration from an O’Neil perspective istwo-fold. On the one hand it allows an investor to fully capitalize on a bigprice move in a winning stock, while on the other it allows the investor tofocus his or her attention on “fewer eggs,” which O’Neil views as a safermental approach than trying to keep track of too many positions at once.Even Livermore himself thought “. . . that it is dangerous to start spreadingout all over the market. By this I mean, do not have an interest in too manystocks at one time. It is much easier to watch a few than many” (How to

Trade in Stocks [Greenville: Traders Press, 1991], 33).To O’Neil, it is not necessary to own every stock in the market; to have

a need to “kiss all the babies,” as he is fond of saying. He whittles it alldown to one basic concept: “The winning investor’s objective should be tohave one or two big winners rather than dozens of very small profits” (How

to Make Money in Stocks, 4th ed. [New York: McGraw-Hill, 2009], 274).

DEALING IN BIG STOCKS ANDINSTITUTIONAL SPONSORSHIP

Owning the biggest winners in the market means owning the stocks that in-stitutions are piling into, and O’Neil sees modern-day mutual funds, hedgefunds, and pension funds, and other members of the “institutional investorzoo,” as akin to the “pools” and “trusts” of Jesse Livermore’s and RichardWyckoff’s era. It is the accumulation of stock by large institutions that pro-duces the huge price moves upon which O’Neil methodologies seek to cap-italize. And the smart institutions, such as those with the better researchand stock selection skills, are the ones in whose footsteps you want tofollow. O’Neil asserts, “It takes big demand to push up prices, and by farthe biggest source of demand for stocks is institutional investors, such as



mutual funds, pension funds, hedge funds, insurance companies, [etc]. Awinning stock doesn’t need a huge number of institutional owners, but itshould have several at a minimum.” O’Neil continues, “[Diligent investors]look for stocks that are held by at least one or two of the more savvy port-folio managers who have the best performance records” (How to Make

Money in Stocks, 4th ed. [New York: McGraw-Hill, 2009], 193–194).Knowing where the smart money is moving is central to O’Neil’s

methodology, and understanding the quality of institutional sponsorshipcoming into a stock is no different from what Richard Wyckoff advisedwhen he wrote, “It is important to know whether large operators, insideinterests, pools, or the public dominate the market for a certain securityor group.” Wyckoff went on to explain, “The reason this is so importantis as follows: A combination of bankers will seldom be found on the longside of the market unless they expect a pronounced change in securitymarket conditions in the near future. Their own purchases, therefore, arean indication of probable betterment. When a pool takes hold, it is usuallyin a certain one or a few issues which are likely to be favorably affectedby developments known to a few but not generally known” (How I Trade

and Invest in Stocks & Bonds [New York: The Magazine of Wall Street,1924], 183).

O’Neil’s unique and deep understanding of the institutional investorand the implications of institutional sponsorship is founded in the expe-rience he has had advising some of the largest and most successful in-stitutional investors on the planet. It is this understanding that generateswhat we have dubbed The Big Stock Principle that drove O’Neil’s think-ing in any market cycle. Knowing which stocks represented the cuttingedge of developments driving any particular economic, and hence market,cycle means knowing where institutional investors “have to be” with re-spect to positioning their portfolios. When institutional investors startshoveling money into stocks that they “have to be” invested in, this fuelstremendous upside price moves in those stocks, and it is what makes them“Big Stocks.” It is a central tenet of O’Neil-style investing.

CHART PATTERNS

Books like How I Made $2 Million in the Stock Market, by the famousballroom dancer Nicolas Darvas, figure into O’Neil’s concepts of “bases,”which Darvas termed “boxes.” O’Neil, however, took it quite a bit fur-ther with his colorful, descriptive cataloguing of consolidation patternsor bases that he termed “ascending,” “cup-with-handle,” “double-bottom,”“square box,” “flat base,” and “high, tight flag,” among others—the chart



patterns from which, as O’Neil observed, big, winning stocks emerged asthey started their huge upside price romps. As well, these patterns rep-resented the “continuation” that patterns hugely performing stocks formon the way up as they naturally and normally pause and digest their gainsduring an overall intermediate to longer-term price run before proceedinghigher.

Like O’Neil and his bases, Darvas’s “box theory” emerged from his owndirect observation and study of stock charts and tables: “I started to realizethat stock movements were not completely haphazard. Stocks did not flylike balloons in any direction. As if attracted by a magnet, they had a de-fined upward or downward trend which, once established, tended to con-tinue. Within this trend stocks moved in a series of frames, or what I beganto call boxes. They would oscillate fairly consistently between a low anda high point. The area which enclosed this up-and-down movement repre-sented the box or frame. These boxes began to exist very clearly for me”(Nicolas Darvas, How I Made $2 Million in the Stock Market [New York:Carol Publishing Group, 1998], 51).

O’Neil is far more specific, however, about the precise structure ofthese “boxes” or “bases,” and his work goes into much detail about theexact shapes, durations, and magnitudes of these various price consoli-dation structures. But, like Darvas, O’Neil recognizes: “Chart patterns aresimply areas of price correction and consolidation, usually after an ear-lier price advance. The primary challenge in analyzing price consolidationstructures is to diagnose if the price and volume movements are normal or,instead, signal significant weakness or distribution” (How to Make Money

in Stocks, 2nd ed. [New York: McGraw-Hill, 1995], 161).It is, however, important to understand that Darvas’s “box theory” is

nothing more than a very rudimentary, initial version of O’Neil’s chart pat-tern zoo. Darvas never bothered to measure the minimum durations for hisboxes to determine whether a longer duration was preferable to a shorterone, nor did he measure the magnitude, or range, of these boxes to deter-mine any meaningful characteristics thereby. As he puts it, “I found that astock sometimes stayed for weeks in one box. I did not care how long itstayed in its box as long as it did—and did not fall below the lower framefigure” (How I Made $2 Million in the Stock Market [New York: Carol Pub-lishing Group, 1998], 52).

O’Neil also went way beyond the simplistic “box theory” by recogniz-ing the importance of applying historical precedent in his work. O’Neilobserved that the chart patterns formed by market-leading stocks in onemarket cycle often repeated themselves in the market leaders of a latercycle. As an example, O’Neil has discussed in public forums how a big pull-back by America Online (AOL) to its 50-day moving average back in 1998

what the market will do is anyone’s guess....

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